Value Investing – Industry Principles and Standards (Lesson 25)<\/span><\/strong><\/span><\/h1>\n

Shifting from economic wide factors that impact market price to industry wide standards is essential with understanding and creating decision models for investment with a pool of similar companies. Industry standards are a part of the spectrum of business principles. This spectrum starts with tenets, universal rules that can not be broken by anyone in business. With value investing, the focus is on the primary business tenet of buying low and selling high. It is an undeniable requirement to increase one’s wealth. The spectrum moves towards core business principles that sometimes are not universally applicable. The final set are industry standards. Each industry has its own unique set of principles it must follow to be successful. Some are a function of law, others are driven by consumer expectations or the culture of the industry. For value investors, understanding this dynamic set of standards for each industry drives the holistic thinking of effective investing.<\/span><\/p>\n

Value Investing – Industry Standards, A Pyramid of Principles<\/span><\/strong><\/h2>\n

There is no universal finite set of business principles. In the aggregate, there are over several hundred of them. Many of them are not applicable to every industry; on the contrary, many are specific to a unique business or industry. The best approach to understanding business principles is to look at this in a holistic manner, i.e. overall doctrine down to a few rules specifically designed for that one business.<\/span><\/p>\n

In effect, think of business principles as an inverted pyramid. The base of the pyramid consists of business tenets, common universal principles. Tenets support the next level, fundamentals. Fundamentals are the more common thoughts that most business managers use to govern their operation. However, some of these fundamentals are not applicable to all corporate operations. At this level, there begins separation of the tenets of business based on multiple variables including markets, business sectors and the underlying industries, customers, employees and vendors. In many cases, this level of the pyramid is impacted by law based on the various levels of our government system. The final tier supported by fundamentals is called standards. This level of principles involve customs, guidelines, rules<\/span><\/strong><\/a> and procedures.<\/span><\/p>\n

Look at this depiction:<\/span><\/p>\n

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Notice that tenets are relatively few, again they are universal in nature and applicable across all industries. Fundamentals are the bulk of principles that exist. The reason for this is that many fundamentals are set by economic restrictions and law. The final upper tier is industry and business specific principles and are uniquely defined by the sector and industry.<\/span><\/p>\n

This article is merely an introduction to the pyramid, other articles on this site go in-depth related to each of the tenets of business and of course fundamentals. Many of the standards are located in the <\/span>pool of investments of this site and often include the respective accounting processes and operational issues the industry uses to implement the fundamentals.<\/span><\/span><\/p>\n

To illustrate, a tenet of business is cited. The fundamentals of its importance are compared and contrasted using two different business operations. The comparison does not cover all the standards for each of the two business operations but just identifies one or two standards they each may use to comply with their respective fundamentals.<\/span><\/p>\n

Tenets<\/span><\/strong><\/h3>\n

Principles that are universal to all businesses are tenets of business. If any single business or industry can operate without this tenet or can break this principle, then this principle is really a fundamental and not a tenet. The principle must be applicable to all industries, all sectors, all aspects of operations and dealings with employees, customers and vendors.<\/span><\/p>\n

As example, there is one tenet that all corporations must follow.<\/span><\/p>\n

Efficiency and Effectiveness<\/span><\/strong><\/span><\/span><\/p>\n

Efficiency and effectiveness are the yin and yang of business. When one of these two elements is given more credence then the other element falters. The key is to balance them appropriately. This balancing act is different for every industry and is customarily driven by the respective purpose.<\/span><\/p>\n

Efficiency refers to utilizing the least amount of resources to deliver the product or service. Intuitively, many companies focus on efficiency as this reduces the overall cost allowing for a profit on the bottom line. Effectiveness refers to delivering the correct product or service. Without it, the customer is highly unlikely to purchase again in the future. Every company must weigh these two elements in delivering the product or service. Use poor quality parts or resources to reduce costs (increasing efficiency) and the company increases the risk of being ineffective with delivering the product or service.<\/span><\/p>\n

Remember though, certain industries will place more value on one element over the other as the other element may not be as valuable to the customer. For example, think of a medical surgeon. Undoubtedly, a surgeon needs to be effective, many people will say no matter the cost. However, this isn’t true. You see, the surgeon is bound by the hospital’s need to exercise efficiency to keep costs down in order to comply with insurance company restrictions. Furthermore, many families simply cannot afford to pay an open-ended arrangement to be effective with the surgery no matter the cost. As the importance of one element increases the other can give but there are limits.<\/span><\/p>\n

On the flip side are businesses that place a lot of emphasis on efficiency and less on effectiveness. However, they must still deliver the product or service the customer demands.<\/span><\/p>\n

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A good example is the electric utilities business. Efficiency, both scientific and administrative are necessary to keep costs under control. For them, every step of the process requires efficiency to reduce costs. For the consumer, they are only interested in having the source of energy at 120 volts, 60 Hertz. Thus, it is easy for an electric utility company to be effective, but difficult to maintain efficiency. Thus, the emphasis is with efficiency over effectiveness.<\/span><\/p>\n

This efficiency\/effectiveness tenet exists across all business sectors and industries. However, the fundamentals will be different tied to the respective sector and industry.<\/span><\/p>\n

Fundamentals<\/span><\/strong><\/h3>\n

Fundamental principles are not always universal. For some industries, certain principles are solely theirs. That same principle may not be applicable to another industry. For example, there is a principle with business known as the range of production<\/span><\/strong><\/a>. It’s basic definition states that a business should produce products at the maximum point of production (think of a manufacturing plant) to maximize profits. This principle assumes all products produced will be sold in the market.<\/span><\/p>\n

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